Due Diligence Obstacle Course

by Dan Doyle Sept/Oct 2013
Attorney Dan Doyle discusses the recent decision in Caterpillar Financial Services Corporation v. Peoples National Bank, which could make refinancing leased equipment more complicated and cause leased equipment to be less valuable, if the opinion is strictly applied outside of the Seventh Circuit.

A recent U.S. Seventh Circuit Court of Appeals decision, Caterpillar Financial Services Corporation v. Peoples National Bank, N.A.1 would make this refinancing transaction more complicated, require much more due diligence and make the prospect of such equipment refinancing much less attractive to lenders. Higher transaction costs and delay triggered by higher level of due diligence may make some lenders reluctant to buy out leased equipment for their borrowers. Consequently, the value of equipment leases may have been diminished by a recent Seventh Circuit opinion that advises lenders how best to refinance leased equipment to make sure the equipment ultimately is available to pay the loan after default. The opinion suggests lenders seeking to succeed to an equipment lessors’ priority in the leased equipment must run a rigorous due diligence obstacle course to ensure a perfected senior security interest in equipment. The suggested process may be so laborious and create such uncertainty, however, as to discourage the buyout of leased equipment by third-party lenders looking to add the equipment to their collateral securing a loan refinancing.

Case Summary

The case involved an Illinois coal mining company, S Coal Company, which purchased coal mining equipment from Caterpillar Financial (CFSC), obtained working capital financing from Peabody Energy Company, and purchased additional mining equipment from People’s National Bank. A couple of years later, S Coal in 2006 needed to restructure its debts to obtain more working capital.

CFSC, with Peabody’s cooperation, refinanced not only the equipment it had previously sold to S Coal that was secured by a first-priority purchase money security interest, but also financed the buyout of leased mining equipment from a number of lessors. Some of those were finance leases containing purchase options at nominal amounts.

Two years later, People’s National Bank in 2008 loaned S Coal additional working capital secured with a wall-to-wall lien that included the borrower’s mining equipment. The bank received a subordination agreement from Peabody. When S Coal financially collapsed, the bank took control of $2.4 million in coal mining equipment in which CFSC claimed a senior lien. CFSC sued the bank for the equipment sale proceeds.

CFSC prevailed at trial in the District Court for the Southern District of Illinois.2 The bank appealed. The appellate court decided the case in CFSC’s favor on other grounds, namely that the absence of a Peabody security agreement predating CFSC’s financing statement prevented the bank from having a first-priority interest through its subordination agreement with Peabody.

The Seventh Circuit’s appellate decision nonetheless discussed at length CFSC’s theory that loaning the borrower money to enable it to acquire ownership of the previously leased coal mining equipment created a purchase money security interest (PMSI) in the equipment.

Purchase Money Priorities and Lease Transactions

A purchase money security interest (PMSI) may arise under Article 9 of the Uniform Commercial Code when a creditor makes a loan to a borrower to enable it to acquire rights in collateral securing the loan. PMSIs arise when the loan pays “all or part of the price of collateral,” or value is given “to enable the debtor to acquire rights in or the use of collateral.” UCC 9-103. To trump the rights of all other creditors in the collateral, the PMSI must be perfected by filing a financing statement within 20 days after delivery of the goods acquired through the lender’s financing. A purchase money security interest takes priority in payment over a pre-existing lender that had earlier perfected a floating lien in all of the borrower’s current or later-acquired equipment or other personal property.

Without a purchase money security interest, the UCC priority rule of “first in time, first in right” generally applies in determining which lender has the right to repossess the collateral and apply the proceeds to its loan. The determination of which lender first perfected its interest usually involves searching financing statements filed with the secretary of state.

Lease transactions governed by Article 2A of the UCC may add a substantial number of wrinkles to what are clear rules about priority of secured lenders’ security interests in a borrower’s collateral. Section 1-203 of the UCC is an analytical framework for distinguishing “leases” from “security interests.” A security interest simply is an interest in personal property that secures payment of an obligation; whether a lease transaction is actually a secured transaction is fact-intensive and complex. Generally, a lease is a secured transaction that must be perfected to achieve priority over other security interests if the lessee cannot terminate the lease and one of four factors exist: 1) the lease term is equal to or greater than the economic life of the leased goods; 2) the lessee must renew the lease beyond the goods’ economic life or must become owner; 3) the lease renewal option requires little or no additional consideration to extend it beyond the leased goods’ economic life or 4) the lessee may opt to own the goods for little or no additional consideration. Courts generally focus on the easiest to prove of the quartet — a purchase option for a nominal or no additional amount.

A refinancing lender puts more value on acquiring a purchase money security interest from the original lender, rather than relying on its analysis of financing statements to determine payment priority in case of business failure. The UCC preserves PMSIs even if the original obligation is refinanced. Therefore, if a lease debt is refinanced, it retains its purchase money character if it is actually a disguised sale agreement but meets PMSI requirements.

The Seventh Circuit’s PMSI/Lease Purchase Analysis

Getting back to the CFSC case, the Seventh Circuit legal opinion drew on these UCC concepts of purchase money security interests, finance leases and priority of payment of security agreements in setting out what it believed were the hurdles that must be overcome for a refinancing lender to take a PMSI in leased equipment bought with the lender’s loan proceeds.

In the S Coal refinancing, CFSC provided additional credit to enable the debtor to own equipment it had been leasing. The plaintiff’s backup argument was that the refinancing was a purchase money obligation because it enabled the debtor to buy the equipment off lease, creating a PMSI. The Seventh Circuit didn’t buy that argument, although no contrary case law apparently existed.

The court assumed the equipment was all subject to disguised security agreements, instead of market rate, operating, or true leases. The court opined that if CFSC had relied solely on acquiring PMSIs on the equipment in the refinancing, it would have lost.

The Seventh Circuit called them “financial leases” under which the lessors were not the equipment owners, but were equipment lenders. The court reasoned that CFSC provided the borrower with a new loan to allow S Coal to complete the lease payments and acquire title, rather than refinancing actual leases.

Judge Richard Posner, writing for the court, posited that CFSC could have preserved the lessors’ PMSI only by obtaining an assignment of the lessors’ pre-existing security interests before refinancing the equipment lease debt. That assumes the lessor created and perfected a PMSI by 1) having language granting security interests in the lease agreement; 2) filing a financing statement in the appropriate place that adequately described the leased equipment and adequately identified the lessor by name; and 3) filing the financing statement within 20 days after the lessees receipt of the equipment. And all that assumes the refinancing lender has done its homework in determining that the lease was not a “true” lease. A lender would be required to complete a complicated, time-consuming and costly checklist to perfect a senior security interest in loaning money to a lessee to purchase its leased equipment. The lender must:

• Determine whether each equipment lease is a finance or a “true” lease;
• If a finance lease, the lender must check equipment delivery dates, the financing statements’ filing dates, their description of the equipment and their identification of the lessor to ensure perfection of purchase money security interests;
• Execute assignments of equipment leases from the lessor to the lender;
• File assignments of lessors’ prior financing statements (if a finance lease), or file original financing statements covering the acquired equipment within 20 days after the borrower acquires title to the equipment; and
• Only then refinance the borrower’s lease obligations to pay off the lease “loan,” or to allow the borrower/lessee to acquire title.

In conclusion, the transactional hassle and costs of a lender attempting to refinance leased equipment to allow the lessee-borrower to buy the equipment is sufficiently problematic under the Seventh Circuit’s logic that it may chill the refinancing of lease debt. The uncertainty cast by this court decision on the ability of a lender to emerge with a purchase money security interest after a lease-purchase transaction may make such transactions less attractive and leased equipment less valuable if the court opinion embraced and strictly applied outside the Seventh Circuit.3

Dan Doyle is a partner at Lathrop & Gage. He represented Caterpillar Financial in its win both at trial in federal district court and on appeal before the U.S. Seventh Circuit Court of Appeals in the case he discusses in this article.

Footnotes:

  1. 710 F.3d 691 (7th Cir. 2013) (Posner, C.J.).
  2. Caterpillar Financial Services Corporation v. Peoples National Bank, N.A., and S Coal Company, 2011 WL 5403501 (S.D. Ill. Nov. 8, 2012).
  3. The Seventh Circuit is composed of federal courts in Illinois, Indiana and Wisconsin.

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